October 17, 2018: Version 3

A Toolkit for Informality Scenario Analysis: A User Guide

Norman Loayza and Claudia Meza-Cuadra

When using these data please cite as follows:
Loayza, Norman and Claudia Meza-Cuadra. 2018. “A Toolkit for Informality Scenario
Analysis.” Washington, DC: The World Bank.
http://www.worldbank.org/informality
Please also cite and refer to the following paper:
Loayza, Norman. 2016. “Informality in the Process of Development and Growth.”
The World Economy 39 (12): 1856-1916. https://doi.org/10.1111/twec.12480

Aim
The aim of this tool is to allow the user to generate estimates of the size and evolution of
informal labor for over 100 countries over the next 20 years.
The tool implements the model described in Loayza (2016), in which the labor force is
allocated into three sectors: the formal sector, the modern informal sector, and a
rudimentary informal sector. Using historical data and exogenous projections from the ILO
and World Bank, as well as estimates of key parameters from the literature, the solutions of
the model allow us to generate annual projections for the size of each sector from now until
2040.

The estimates and projections

As described in section 4 of the paper, the basic parameters used in the projections are: the
subjective rate of time preference (ρ), the capital depreciation rate (δ), and the Cobb-
Douglas output elasticity of labor (α). The initial conditions used are estimates of the
capital stock, total factor productivity (TFP), the labor force, and the share of formal and
informal labor, both rudimentary and modern.
Estimates of informal labor are derived from ILO estimates (ILO, 2018) recently published.
The categories of employment are attributed to the two informal sectors described in the
model based on their characteristics. First, workers that the ILO classifies as in formal
employment are allocated to the formal sector. Next, employers whose production units
are considered to be part of the 'informal sector' (ILO, 2018) are allocated to the modern
informal sector. Similarly, 'employees and contributing family workers in informal
employment in the formal sector' are added to the modern informal sector. This is also the
case with 'employees in informal employment in the informal sector' (ILO, 2018). Finally,
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all other workers are allocated to the rudimentary sector.1 For a subset of countries
missing new estimates from the ILO, the set of available estimates of rudimentary and
modern informal labor are regressed2 on historical GDP, pension coverage and vulnerable
employment to generate estimates.
The exogenous projections needed for the simulations are future population, labor force,
and TFP growth rates. The main distortions are the legally mandated labor cost (W), the
excess capital costs for informal firms (ζ), and the difference in labor productivity between
formal and modern informal firms (a) as well as between formal and rudimentary informal
firms (b).

Note that in order to be consistent with the model described in the paper, we use two sets
of equations for developing the projections, depending on the presence or absence of
migration from a rudimentary economy into the modern economy. When the rudimentary
sector reaches a minimum (set to a default value of 5% of the labor force in the
projections), the equations in Section 3.2 (The modern economy in the presence of a
rudimentary economy) are no longer applicable, and those in Section 3.1 are used.3

Using the tool

The tool allows the user to customize the settings for all of the variables used in the
projections including time frames over which to average historical data and initial values
and annual growth rates for parameters.
A user-friendly “Menu” tab allows the user to choose from a range of key options and
scenarios pre-selected by the authors. A chart and table summarizing the projections for a
chosen country are automatically generated. A summary of the projections for all of the
countries is also available at the bottom of the screen.
The “Initial Conditions and Settings” tab allows users who are comfortable with Excel to
further customize the projections. Annual projection data for all countries using informal
labor as a share of employment or the labor force can be viewed in the “Projections (% of
employment)” or “Projections (% of labor force)” tabs.

1
Estimates from the ILO were incomplete for 4 countries: the United States, Iraq, Russian
Federation, and the United Kingdom. To fill in the data, values were calculated as residuals and,
additional assumptions were made when necessary. For example, for the UK, the number of
'contributing family workers' was assumed to be 0. In addition, for Iraq, average shares across
the region were used to estimate the share of 'own-account workers' in the informal sector.
2
A logit regression with region fixed effects is used.
3
Users can establish a minimum for the size of the informal modern sector and change the
value for the rudimentary sector using the “Initial Conditions and Settings” tab.
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a. Using the Menu tab

Basic Options
Country or Region: choose the country, region, or group for which results will be displayed.
A table with results for all countries (excluding outliers and countries with small
populations) is available at the bottom of the screen.

Range for Background Data: choose the minimum and maximum year over which to
average historical data for all initial conditions except the growth rates of the labor force,
capital and TFP and the labor force (2000-2016),

Absolute % difference in growth rates of labor costs and labor productivity under Populist or
Reformist scenario: i.e. for the Populist scenario choose how much slower labor
productivity grows than labor costs, and vice-versa for the Reformist scenario. The default
is 0.5%

Project informal labor as a % of Employment or Labor Force: choose estimates of

employment as a share of total employment or as a share of the labor force. Labor force
estimates are derived from estimates as a share of employment, allocating a portion of
unemployment to the formal sector (corresponding to the natural rate of employment) and
the rest to the two informal sectors, proportionately. This reflects the fact that informality
is often driven by the same factors as unemployment. Estimates are similar though can
vary significantly for countries with high rates of unemployment.

Natural rate of unemployment: choose a rate of natural unemployment. When changing this
parameter, this value will be applied to all countries in the projections.

Growth rate of A: choose the growth rate of A (productivity of the formal sector in the
model, approximately TFP). The default setting is for each country to use the historical
average of TFP growth in that country from 2000-2016. When changing this parameter,
this value will be applied to all countries in the projections.

Other Parameter Growth Settings4

In this section, the user may define annual growth rates for each parameter to generate
scenarios where informality is more or less persistent (e.g. see the “Persistent Informality”
scenario described in section 4.2. Projections in Loayza (2016). When the growth rates are
set to 0 or blank, μ, ζ, a and b are projected to be constant over time.

4
The initial values of μ, ζ, a and b may be changed in the “Initial Conditions and Settings” tab.
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The authors propose two sets of default growth rates which may be appropriate for
developing or developed countries.
Use default settings for persistent informality in developing countries: use 1% growth rate for
μ, 0.25% growth rate for a, 0.25% growth rate for b, and -0.25% growth rate for ζ. This
leads to more persistent informality in developing countries under the baseline scenario.
Use default settings for persistent formality in developed countries: use 0.5% growth rate for
μ, 0 % growth rate for a, 0% growth rate for b, and 0 % growth rate for ζ. This leads to
more persistent formality in developed countries under the baseline scenario.
While users can also change the growth rate of each parameter manually, this option
should be used with caution.
Changing cost of living in the modern economy (μ): set growth rate for the difference in cost
of living between the modern economy and the rudimentary informal sector. The initial
value is set to 1.81, and a positive growth rate will mean a growing gap in the cost of living
in the two sectors.
Changing relative productivity of the modern informal economy (a): set growth rate for the
ratio between the productivity of the formal and the informal modern sector. The initial
value is set to 0.71, and a positive growth rate will mean a decreasing gap in the
productivities of the two sectors.
Changing relative productivity of the rudimentary informal economy (b): set growth rate for
the ratio between the productivity of the formal sector and the rudimentary informal
sector. The initial value is derived from the solutions of the model and is country-specific. A
positive growth rate will mean a decreasing gap in the productivities of the two sectors.
Changing relative cost of capital in the modern informal sector (ζ): set growth rate for the
ratio between the cost of capital faced by informal modern and formal firms. The initial
value is set to 1.3, and a negative growth rate will mean a decreasing gap in the cost of
capital in both sectors.
Snapshot of projections for all countries
Choose Scenario: choose between Populist, Baseline or Reformist scenario where, in
the formal sector:
• Populist: Labor productivity grows slower than labor costs (W)
• Baseline: Labor productivity grows at the same rate as labor costs (W)
• Reformist: Labor productivity grows faster than labor costs (W)

b. Using the Initial Conditions and Settings tab

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Time frame for Initial Condition estimates based on historical data: Choose individual time frames
for the historical data averages of the labor force, growth rate of the labor force,
employment, capital, growth rate of capital, GDP, growth rate of TFP, and growth rate of the
labor force.

Initial Parameter Values and Settings for Projections

Initial year for the projections: currently set to 2016. Based on the availability of historical
data, use a year from 1990 to 2016.
Minimum size of the rudimentary economy: choose a lower limit on the percentage of the
labor force that is employed in the rudimentary economy. Currently set to 5%.
Minimum size of the informal modern sector: choose a lower limit on the percentage of the
labor force that is employed in the modern informal sector. Currently set to 0%.
Constant capital share (α): choose an alternative value for the constant capital share of
output for the modern economy. Currently set to 0.5.
Cost of living adjustment from rudimentary economy (μ): choose an alternative value for the
difference in cost of living between the modern economy and the rudimentary informal
sector. Currently set to 1.81.
Ratio between productivities of the modern informal and formal sectors (a): choose an
alternative value for the ratio between the productivity of the formal and the informal
modern economy. Currently set to 0.71.
Ratio between capital rental rate for modern informal and formal firms (ζ): choose an
alternative value for the ratio between the cost of capital faced by informal modern and
formal firms. Currently set to 1.3.
Ratio between wages in the modern informal and formal sectors using constant alpha (pi):
choose an alternative value for the ratio between the informal wage rate and the formal
wage rate, W. Note that it is currently a function of the capital share (α) and the ratio
between the capital rental rates and productivities in each sector (ζ and a), equal to 0.39.
Difference in growth rate of labor costs and growth rate of labor productivity: choose a
growth rate. A positive growth rate tends to decrease formality and vice versa.
Growth rate of a: choose a growth rate for the ratio between the productivity of the formal
and the informal modern sector
Growth rate of b: choose a growth rate for the ratio between the productivity of the formal
and the rudimentary informal sector
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Growth rate of μ: choose a growth rate for the difference in cost of living between the
modern economy and the rudimentary informal sector
Growth rate of ζ: choose a growth rate for the ratio between the cost of capital faced by
informal modern and formal firms
Growth rate of TFP: projections currently use an average of the TFP growth rate from 2000-
2016 for each country, as the future growth rates for A. The user may choose an alternative
growth rate here.

Natural rate of unemployment: choose the percentage of unemployment allocated to the

formal sector. Currently 5% of unemployment is allocated to the formal sector.

Initial Conditions Based on Historical Data, Based on the Model and Settings for Projections
Table 1 shows the country-specific variables used in the projections. The variables in the
first section show averages for the variables based on the historical data in the “Historical
Data” tab, for the years defined above. The equations for the allocation of labor into the
three sectors are also available.
The second section shows the initial conditions based on the equations of the model. For
those variables that depend on the capital share, values are displayed using both the
constant capital share and a country specific share.
The next section consists of dummy variables identifying outlier countries with respect to
various variables and also specific sub-groups (small population, OECD).

Finally, the historical growth rates of TFP and growth rates of the labor force, as well as the
estimates of the subjective rate of time preference plus the depreciation rate are calculated.
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Description of Variables and Data Sources

Variable Description Data Source/ Method

Capital share In the production function of the We use a constant estimate of 0.5. This
(𝛼) modern economy, the capital corresponds roughly to the median value of
share measures the share of country-specific estimates we derived from labor
national income that accrues to shares presented in the Penn World Tables
owners of capital. (averaged from 1990-2016).
Subjective rate The marginal rate of substitution Using the equation that determines the rate of
of time between present and future capital growth in the modern economy and the
preference (𝜌) consumption. average growth rate of capital from 2000-2016,
we obtain the implicit depreciation rate and the
Capital The rate at which the economic
depreciation subjective rate of time preference. We set a
value of the capital stock
rate (𝛿) minimum value of 1 percent.
decreases over time.
Capital stock Goods or assets used for We develop historical estimates using Gross
(K) production in the modern Capital Formation in 2010 US dollars from WDI
economy. (1960-present), extrapolating using Investment
from Penn World Tables (1950-2014) for past
years in which it is not available. For the initial
conditions, we use an average from 2012-2016
and update future years using the growth rate
derived from solutions of the model.
Total factor The total factor productivity of We develop country-specific estimates using the
productivity of firms operating in the formal production function of the modern economy and
the formal sector, using capital and labor. our estimates of capital and labor in the modern
sector (A)
economy. For the initial conditions of the
underlying data, we use an average from 2012-
2016.
Growth of Growth of total factor We calculate an annual log growth rate of the
Total factor productivity of firms operating in historical estimates of TFP and take an average
productivity of the formal sector, using capital from 2000-2016. TFP is calculated using capital
the formal and labor. estimates, total employment and GDP. We set a
sector (A) minimum value of 0.
Growth of the Growth of the total labor force We use estimates and projections of the size of the
Labor force (i.e. in the modern and labor force by country from the ILO (available
rudimentary economy) by until 2040) to find an annual growth rate. For the
(growth of LF +
country. initial year, we use an average of estimates of the
L I + L R)
size of the labor force from 2012-2016 from WDI
and update this using the projected growth rate.
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Variable Description Data Source/ Method

Excess capital Informal firms pay a capital rental Based on an estimate by Scheinkman and de Paula
costs for rate which is a multiple, R , of the of the additional cost of capital for informal firms
informal firms market determined net capital in Brazil, we assume a constant value of 1.3 for all
(ζ) rental rate paid by formal firms.
countries. For the persistent informality
parameter options, we set ζ to decrease 0.25%
percent annually.

Cost of Living The wage adjustment between We find the ratio between the average monthly
Adjustment the rudimentary and modern wage of all employees and of employees in
(μ) economies, which accounts for elementary occupations, available for a subset of
differences in the cost of living or countries from the ILO. We use the mean, after
in the cost of labor participation excluding outliers, 1.81. For the persistent
between the two economies. informality parameter options, we set the growth
rate of μ to be 1 percent annually.
Ratio of formal Total factor productivity in the We use an estimate from Perry (2007) that,
to modern informal sector is a fraction, a, of controlling for firm characteristics, informal firms
informal productivity in the formal sector are 71% as productive as formal firms. For the
productivity (A). persistent informality parameter options, we set
(a) the growth rate of a to be 0.25% percent annually.
Ratio of formal Labor productivity in the Country-specific estimates are obtained through
to rudimentary economy is a calibration of the model. For the persistent
rudimentary fraction, b, of total factor informality parameter options, we set the growth
informal productivity in the formal sector. rate of b to be 0.25% percent annually.
productivity
(b)
Formal Labor The total share of workers We use estimates of informal labor from the ILO
(LF) employed in formal jobs. (ILO, 2018) to identify formal labor. For the
estimates as a share of the labor force, we allocate
an additional share of the labor force to be formal
As a share of (default is 5%). For a subset of countries, a logit
labor force or regression of informality and historical estimates
employment of GDP (WDI), contribution to pensions (ILO and
World Bank) and vulnerable employment (ILO)
(averages from 2012-2016) are used to fill in
missing data.
Informal The total number of workers in We use ILO estimates of informal employment by
Rudimentary the rudimentary economy, using sector and status in employment to allocate a
Labor (LR) primary production technologies portion to the rudimentary sector and the rest to
with little capital and low the modern informal sector. For a subset of
productivity countries, a logit regression of informality and
historical estimates of GDP (WDI), contribution to
pensions (ILO and World Bank) and vulnerable
employment (ILO) (averages from 2012-2016) are
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Variable Description Data Source/ Method

used to fill in missing data.
Informal The total number of workers We use ILO estimates of informal employment by
Modern Labor employed in informal firms sector and status in employment to allocate a
(LI) operating in the modern portion to the rudimentary sector and the rest to
economy. the modern informal sector. For a subset of
countries, a logit regression of informality and
historical estimates of GDP (WDI), contribution to
pensions (ILO and World Bank) and vulnerable
employment (ILO) (averages from 2012-2016) are
used to fill in missing data.
Legally The legally mandated cost of We use the equation for the aggregate capital-
mandated labor paid by firms in the formal labor ratio in the modern economy to derive an
labor cost, i.e. sector. estimate.
minimum
wage (W)

REFERENCES
Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer. 2013. "The Next Generation of
the Penn World Table." Available for download at www.ggdc.net/pwt.
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ILO and WIEGO. 2012. “Statistical Update on employment in the informal economy.” ILO
Department of Statistics.
ILO. 2018. “Women and Men in the Informal Economy: A Statistical Picture.” Third Edition.
https://www.ilo.org/global/publications/books/WCMS_626831/lang--
en/index.htm
Loayza, Norman. 2016. Informality in the Process of Development and Growth. Policy
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http://documents.worldbank.org/curated/en/998481476291165295/Informality-
in-the-process-of-development-and-growth
Perry, Guillermo. 2007. Informality: Exit and Exclusion. World Bank Publications.
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and figures.” Social Protection and labor discussion paper; no. SP 1211. Washington,
DC: World Bank.
Scheinkman Jose A. and Aureo de Paula. 2011. “The Informal Sector: An Equilibrium Model
and Some Empirical Evidence from Brazil.” Review of Income and Wealth 57, S1: S8-
S26.
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Washington, DC: World Bank.
World Development Indicators, latest available. Washington, DC: World Bank.